Market forces set to take charge in Chinese listings (well, almost)

PHILIPPE ESPINASSE

China's government recently stirred local stock markets by signaling the end of a ban on new listings on the Shanghai and Shenzhen bourses and the ChiNext board. Still, the 760-plus applicants who have been waiting in the wings -- some for nearly 14 months -- should not get too excited. In the first days of the new year, the authorities granted two batches of approvals for a total of 11 initial public offerings.

Under new guidelines issued by the China Securities Regulatory Commission (CSRC), underwriters will have a much larger role in determining key matters such as pricing and allocations. But government regulators will retain a heavy hand in managing the new issue pipeline in what will remain, for the foreseeable future, a mainly domestic capital market.

According to the CSRC, a total of some 50 companies may be approved for IPOs by the end of January. This would be a significant development in a market that had seen dwindling new-issue volumes even before the ban. In 2010, 471 companies were listed, raising a combined $71 billion. The tally fell to 265 in 2011, and further to 152 in 2012, when the last IPO to date closed in November.

China froze IPOs on the mainland in October 2012 after a series of accounting and fraud scandals at newly public companies. At the end of that year, the CSRC initiated an inspection of 622 IPO applicants and securities intermediaries. That led to the termination of 268 listing submissions, or just under 31% of those pending review.

The resulting reforms should favor better-quality issuers and provide more adequate protection for the nearly 90 million individual investors in the country's two largest market platforms. China may be home to some of the world's top banks by assets, but its institutional investor base remains small: about 60% of the transaction volume on the mainland's exchanges is by individuals investing less than 500,000 yuan ($82,624) each.

Five priorities

The reforms zero in on five key areas. The first focus is the promotion of a market-oriented IPO regime. This includes early publication of an approved issuer's prospectus on the CSRC's website (a measure also implemented in Hong Kong last October); the introduction of preference shares; and requiring the same disclosure for "backdoor" listings as for bona fide flotations. Importantly, issuers will retain discretion over the timing of their IPOs after applications have been approved.

The second priority relates to the fiduciary duty of issuers and their shareholders. Sales of shares by controlling stakeholders, directors and senior executives within two years after the lock-up period will not be authorized at prices below the IPO price. Extended periods of continuous trading below that level within six months of listing will lead to an extension of the lock-up itself. Major shareholders planning share disposals will also be required to signal their intentions early.

The third and fourth tenets of China's new listing regime, which cover IPO pricing and allocations, stand to be warmly welcomed by equity capital market practitioners. Pricing will now be determined through negotiations between issuers and underwriters. IPOs will feature a prescribed minimum of institutional and individual investors to achieve optimal aftermarket liquidity. If a company's valuation is set at a significant premium to listed comparables, this will trigger requirements for additional information.

Share allotments will primarily favor securities investment and social insurance funds, with clawback mechanisms that transfer shares from public subscription to institutional investors, similar to those already in place in Hong Kong.

Last, there will be stringent requirements for post-IPO disclosure by listed issuers. First-day share price "pops" for IPOs will now be capped, while temporary trading suspension measures will also be introduced to avoid repetition of the triple-digit percentage gains often seen in the past.

These reforms will further align China's listing process with those of major international exchanges. At least to some extent, however, the CSRC will undoubtedly continue to regulate the pace of issuances.

In addition, the qualified foreign institutional investor quota is currently capped at just below $50 billion (equivalent to 1% of the assets under management by Fidelity Investments) and spread across only 243 approved institutions. This means the Chinese capital market will retain its largely domestic nature, limiting the extent to which market forces can influence publicly quoted corporations.

But as to a big investor concern about the changes -- that a wall of new issues could flood and depress the mainland's exchanges -- the introduction of market-based elements to IPOs will hopefully introduce some form of "Darwinian" selection before deals can successfully make it to pricing.

No matter how incremental, the reforms constitute a major -- although not yet giant -- step on China's long march toward market-based capitalism.

Philippe Espinasse was an investment banker in the U.S., Europe and Asia for more than 19 years and is now an independent consultant in Hong Kong. He is the author of "IPO: A Global Guide." His new book, "IPO Banks: Pitch, Selection and Mandate," will be published later this year.